This blog accompanies Episode 4of The Retirement Oasis Podcast. To listen to the podcast, you can visit your favorite podcast platform (Apple, Stitcher, Podbean, etc.) or go here:
The number one question when it comes to retirement is “When can I retire?” or “Can I retire at age X?” This question is usually answered by knowing how much you need in your retirement portfolio at Day One of retirement. In other words, “what is my number?” or “how much is enough?” It’s obviously a different amount for each person since it is impacted by many factors. And, it’s important to understand that there is not always a clear-cut answer since many of the relevant variables are uncertain.
In today’s blog and in the associated podcast, we will talk about some of the key variables that play into answering the question, “How much do I need before I retire?” We have a client, Randy and Rhonda Retiree, who wants to know their number. We’ll meet them in a few minutes.
It’s Not All About the Numbers in Planning for Retirement
Before we delve deeper into this fundamental retirement planning question, it’s helpful to remind us all that it’s not all about the numbers. Planning for retirement is much more than just “how big does my retirement portfolio need to be before I can retire?” Unfortunately, however, that question receives much of the focus and for many individuals – and even for advisors – planning for retirement is merely focused on the numbers and the analysis of whether I have enough. The primary focus, the starting point in thinking about planning for retirement, is to realize that the retirement years can be an amazing time in one’s life -- living with freedom and with purpose can lead to many years of a fulfilling life. There’s a lot to unpack there and certainly a lot more we want to explore about how to live a fulfilled life in retirement in future blogs and episodes; nevertheless, we know that analyzing retirement from a numbers’ perspective is a necessary and beneficial exercise.
Other Important Strategies to Consider in Retirement Planning
One further word before we look at this somewhat myopic view of retirement planning is to remind you that retirement planning, if done right, includes many strategies that can enhance your ability to create a more secure retirement. The amount you need in your retirement portfolio at retirement is affected by these strategies: minimizing income taxes before and during retirement, crafting a plan to move your portfolio from a pre-retirement-date growth focus to a post-retirement-date focus on growth plus a portfolio paycheck, dialing in the right asset allocation, knowing the best time and way to take Social Security benefits or a pension, using debt effectively, and others. We will cover these in future blogs and episodes of our podcast but for now, we should note that these and other strategies have the potential to enhance retirement from a financial perspective and could alter the analysis of the “how much is enough” calculation.
The Three Main Factors in Deciding How Much is Enough for Retirement
In its most basic form, the “how much is enough” calculation can be done by considering three factors -- the annual withdrawal amount you will need to maintain your lifestyle and reach your goals (also known as your portfolio paycheck), the duration of your retirement – or how long will you need to pull a paycheck from the assets – and the rate of return of your retirement portfolio.
Actually, the rate of return factor is two factors in one – the rate of return on the investments in the portfolio minus the inflation rate by which the annual withdrawal rate will increase during retirement. We call this the adjusted rate of return – meaning, the rate of return minus the inflation assumption.
Let’s define these three factors before we head into more detail.
The withdrawal amount is one factor in the retirement analysis and is probably the factor that varies most amongst individuals. To determine the annual withdrawal need from the retirement portfolio, the near-retiree needs to figure out many factors around this, including what their ideal retirement looks like because much of what we want to do or accomplish in retirement will impact spending – this, in turn, impacts the withdrawal need. Not all of your retirement goals have a clear financial consequence, but manydo. Of course, you may be thinking that some of your withdrawal needs will be met by added income like Social Security benefits or a pension or annuity. That is certainly true so perhaps we should clarify our terms. When we say ‘withdrawals needs’ or ‘portfolio paycheck,’ we mean the amount of money you need to withdraw from your portfolio beyond your income. In other words, cash comes in (e.g., Social Security, pension), cash goes out (e.g., lifestyle expenses, major purchases) and you have a net cash flow need. That is the amount of the withdrawal we are referring to today – the total spending amount less the income received.
The Duration of Your Retirement
The second factor is the duration of the retirement period. This is pretty straightforward. It’s the number of years from the retirement date until the passing of the client. When selecting a duration, it is not the time to be pessimistic. We’re not asking you to give an opinion about how long you will actually live. We want to be conservative and we do not want you to outlive your money. So, let’s select a duration that goes beyond your life expectancy.
The Adjusted Rate of Return of Your Retirement Portfolio
The third factor is the adjusted rate of return. That is, the expected rate of return on the investments in the portfolio minus the assumed inflation rate.
We could spend many podcasts talking about the expected rate of return but, for today, we need a simple, realistic number to work with. We will use 6%. This is the same number we use in many of our firm’s financial plans for a 60/40 portfolio (60% equities and 40% fixed income) with a reduction for expenses and biases. So, our rate of return is 6% and now we need to subtract our assumed inflation rate.
We won’t spend much time on this topic today, though inflation has made a recent resurgence and is grabbing some headlines. For now, it’s important to think about the connection between the inflation rate and the assumed rate of return on your retirement portfolio. The historical rates of return earned by various asset classes include the inflation rate experienced by investors at that time. It is a genuine concern of many pre-retirees and retirees that inflation will increase their expenses while their portfolio will not keep up. However, it is likely that future rates of return will change as inflation changes. For today, we will use an inflation rate of 2.5%. Okay, enough about inflation for today.
To finish the math on the adjusted rate of return, we will take the 6% expected rate of return and subtract the 2.5% inflation rate to get an adjusted rate of return of 3.5%. Rather than spending any more time on this, let’s just call it a decent starting point and move on. It obviously could be less than that or it could be more, and it will certainly vary each year, but let’s go with that assumption for this quick calculation.
Retirement Calculations and Sensitivity Analysis
There is certainly a lot to unpack in each of those assumptions and we will cover those factors in more detail a bit later in this episode, but I wanted to initially review some of the calculations at a high level and do some sensitivity analysis with these factors.
And these retirement calculations can be done a few different ways using a variety of tools, including a financial calculatoror a spreadsheet with the various input functions and equations. You may have even seen online calculators that use these basic inputs. Of course, more advanced financial modeling software can be used for more precise calculations andto look at planning strategies. For our purposes, we are going to keep it simple and let a financial calculator provide some high-level results.
Let’s Meet the Client!
To walk through these factors and how they are affected by changes, let’s meet the client – Randy and Rhonda Retiree. They want to know how much they need on Day One of retirement.
Randy and Rhonda will need to withdraw $50,000 per year from their retirement portfolio. That’s their Withdrawal Amount. They want to assume that they’ll need this portfolio paycheck for 30 years. That’s the Duration of their retirement. The other big factor is the adjusted rate of return, 3.5%, that we mentioned a few minutes ago.
Plugging in the 3 factors – withdrawal need of $50,000 per year, 30 years of need, and a 3.5% adjusted return – you come up with how much is needed on Day One. With those assumptions, Randy and Rhonda need $919,000 on Day One of retirement. So, a bit under $1,000,000 allows them to withdraw $50,000 per year in retirement under those assumptions. The portfolio will grow with inflation and the $50,000 annual withdrawal can grow with inflation, too. That could be a comfortable lifestyle for them, especially if we factor in other income.
But, that’s not the end of the story. We want to do two things. First, let’s take a look at the sensitivity analysis around how these factors impact the calculation, and then let’s get more into the weeds on these assumptions and some of the variables that we left off.
Sensitivity Analysis Explained
What exactly is sensitivity analysis? In simple terms, we adjust one or more of the factors by a set amount and see what impact the change has on the outcome. For Randy and Rhonda, we will make some changes to their three factors and see how it affects the value of their retirement portfolio on Day One, the $919,000.
Sensitivity Analysis – Withdrawal Amount
Let’s look at the amount of their annual withdrawal and how it impacts the amount needed on Day One of retirement. The original withdrawal amount was $50,000. If Randy and Rhonda want to increase their withdrawal to $75,000 per year, the amount needed on Day One increases to $1.4m, keeping the other two factors unchanged. The withdrawal factor rose 505% to $75,000 but the portfolio amount increased about 52%. That’s a relatively big jump in assets needed and that may surprise some folks. Increasing spending by a mere $25,000 per year requires another $500,000 of retirement assets.
And, I’m sure many of our listeners will say that makes sense – needing another $25,000 per year for 30 years, well that sums up to $750,000 right there. If you assume your investments should get a little bit of growth, then you need less than that. In fact, the relationship of the annual spending amount and the portfolio value on Day One is said to be proportionate. If we increase the annual withdrawal by 50%, like we did here from $50,000 to $75,000, then we would need 50% more in the portfolio on Day One. This is not exactly right in the real world because income taxes will distort that a bit. Ah, income taxes. That’s one of the other factors we haven’t talked about yet. And the numbers would obviously work in reverse if you needed to withdraw less than the $50,000. So, you can see the amount one needs to withdraw obviously has a big impact on the amount needed in your retirement portfolio on Day One of retirement.
Sensitivity Analysis – Duration of Retirement
Let’s take a look at another variable – the duration of retirement – the time from Day One of retirement until your passing, plus a few years to be conservative and make sure you don’t outlive your money. Randy and Rhonda said they wanted to assume a 30-year duration. For now, without getting into the details, let’s look at the sensitivity analysis of the duration.
Instead of a 30-year period, let’s assume a 35-year period. Maybe Randy’s parents are nearing age 100 so he wants to consider what happens if he lives longer than expected. So, for a 35-year retirement, how much more would Randy and Rhonda need on Day One? When we plug the numbers into our trusty calculator, we come up with the magic number of almost exactly $1,000,000. So, if we add 5 years to the duration, Randy and Rhonda need about another $80,000 to meet their needs.
This may seem like a smaller amount than one would have guessed. It is about 9% more than the 30-year period, but Randy and Rhonda are pleased that it did not have as much of an impact as they might have thought. And, one of the big reasons that it did not have as much of an impact is the power of compounding growth and time. That extra $80,000 can now grow for 30 years or more to meet those expenses for those extra 5 years.
Yes, but it is important to distinguish between the duration of retirement and the retirement age. While the retirement age is the starting point to determine the duration, the analysis above does not really take into account different retirement ages. Retiring at 60 versus retiring at 65 will have a much larger impact than merely saying that the duration of retirement is 5 years longer. We won’t get into that calculation here, but that is an important distinction.
So, again, the duration of retirement would obviously impact the amount that Randy and Rhonda need on Day One of retirement.
Sensitivity Analysis – Rate of Return
The final variable that we are using in this simple calculation is the adjusted rate of return. To reframe our assumption, we assumed that the adjusted rate of return was 3.5% and that along with our spending and duration variable resulted in a Day One need of $919,000. Doing some sensitivity analysis around this, let’s assume the rate of return was a bit lower and perhaps the inflation was a bit higher to where the adjusted rate of return was only 2.5%. If we plug in these new numbers, Randy and Rhonda will now need $1,050,000. So, reducing the adjusted rate of return by a mere 1% increases the amount needed at Day One by about 14%. So, I don’t mean to get into the weeds of the calculation, but the rate of return obviously matters. We can obviously have several different spinoff podcast episodes on this one issue – and we probably will. For now, the point is that making the right assumptions and understanding the potential range of outcomes matter. It also shows that achieving a favorable rate of return could obviously impact one’s quality of life.
Of course, with investments, it is not merely going for the highest return at all costs because risk of the portfolio matters. You absolutely do have to take into account risks and consider ways to mitigate risk. That is a topic for another day, indeed.
So, with these illustrations, we meant to highlight the three main variables that go into deciding how much one needs at Day One of retirement and also the sensitivity of the amount needed based on the 3 simple factors - the annual withdrawal need, the duration of retirement, and the assumed adjusted rate of return.
Rules of Thumb in Retirement Planning
In addition to retirement calculators, the industry has developed rules of thumb to help you calculate how much one needs at retirement. As with most calculations and rules of thumb, there is more to the story and certainly much more to planning for retirement in a sensible manner than relying on rules of thumb for retirement planning. Nevertheless, they can be helpful as a starting point to assess your retirement situation.
Multiple of Income or Withdrawal Needs. It is often said that a retiree needs 20-35 times the amount of withdrawals on Day One of retirement. Thus, if that rule of thumb was accurate and using Randy and Rhonda’s spending amount of $50,000 per year, we can see that would equate to $1,000,000 to $1.75 million in Day One funds. And, it’s no coincidence that those numbers are close to the numbers we looked at earlier because the rule of thumb obviously used similar factors in its derivation.
Withdrawal Rate Rule of Thumb. The multiple of income needs approach relates to another rule of thumb in retirement that says you can withdraw a certain percentage of your portfolio in the first year of retirement and annually increase it by inflation. The studies generally suggest that anywhere from 3% to 4.5% might be a reasonable withdrawal rate. If 4% was a realistic number, this would equate to having 25 times the amount of your annual withdrawal needs. We won’t get into the accuracy of the 4% withdrawal rule as that will also be a good episode, but we did want to highlight that and discuss how that relates to the question of “how much is enough”.
Deeper Dive Into the Variables for the Retirement Funding Calculation
Having looked at a couple of rules of thumb, we realize we need to go deeper in explaining this retirement calculation. So, let’s take a deeper dive into some of those variables that we took for granted and review how the real world is not as simple as the financial calculator or any rules of thumb might suggest.
Variable #1 in Retirement Funding Calculation: Withdrawal Need
One of the variables we discussed was the amount of withdraw needed. This is more complicated than a single number for a variety of reasons – one, this variable really includes both a spending amount and an income amount. So, it’s a net withdrawal needed. And, the devil is in the details on those two factors as well. As we stated at the top of the episode, a large component of this is the amount of annual spending. But, the real world is more complicated. Spending patterns typically vary throughout retirement, and they vary by individual. So, again, we cannot stress enough, that it starts with understanding what an ideal retirement looks like for an individual. Once one establishes that, the near retiree can then establish the proper budget that ties to that ideal retirement.
Budget. Coming up with a budget is difficult and is one of the most underrated tasks that we should all be doing. I would put it up there with flossing and hugging your mom as the three most underutilized things we should be doing. We will delve more into developing a budget in another episode, but understanding your current spending is just the starting point. You then need to envision your ideal retirement – what activities are you going to be doing? Are you moving and what’s the cost of living in the new location? Are you buying a second home and what additional costs will that entail?
Expenses vary throughout retirement. Even if we develop an annual spending amount, it does not end there. Spending typically does indeed vary throughout retirement. A lot of times, we work with clients where they may spend a bit more early in retirement since they are more active and healthier in the early years – we call these the go-go years. You need to factor in the extra spending earlier on. Other expenses like mortgage payments and health care expenses may also vary throughout retirement. If someone retires well before the Medicare age of 65, health care expenses can change the calculation significantly because medical insurance can be quite expensive in the pre-Medicare years. So, by diving deeper into this basic assumption and doing more detailed analysis, the “how much is enough” number may change considerably.
Risks of using incorrect living expense assumptions. If someone takes a cavalier approach to understanding his or her budget, the analysis may be a bit off. For example, if someone said they needed $75,000 for each and every year in retirement yet a lot of those expenses consisted of vacation expenses in the early years of retirement, the analysis may be way off. The calculations may suggest that they have to work many years longer than they would otherwise if the proper numbers were used. Not working those “additional years” can be huge for life satisfaction.
Income taxes. A huge expense that is variable throughout retirement and that is often overlooked is income taxes. This is indeed a large expenditure in retirement, and will vary based on the composition of one’s assets, whether the retiree is single or married, and the state of residence that one lives in. We have seen that income taxes can add 5 – 25% or more in one’s spending in retirement. Of course, with good tax planning in pre-retirement and retirement years, this expenditure could be minimized. Nevertheless, income taxes should be a part of the withdrawal factor.
Other income in retirement. Another area where the real world is different from a simple calculation is the fact that there will likely be additional income in retirement. Of course, the biggest income in retirement for most folks is Social Security. Again, the factor that we have been focusing on is the withdrawal need in retirement. In the early years of retirement, Randy and Rhonda may not be taking Social Security. While the decision of when to begin taking Social Security is another episode and the analysis of when to take Social Security is more complex than many people and advisors think, if Randy and Rhonda failed to take this Social Security income into the Day One need calculation, the calculation would probably indicate that they need to work longer - - much longer – than what they otherwise would need.
There are other types of income that could impact the withdrawal need, including pension income, real estate rental income, second careers or side gigs, and potential inheritance. You want to be conservative when making these assumptions – for example, you don’t necessarily want to assume significant income from a second career if you do not have definitive plans. Nevertheless, the point is that to get an accurate calculation of what that Day One portfolio should be is heavily impacted by the amount and timing of income that one expects to receive in retirement.
Variable #2 in Retirement Funding Calculation: Duration of Retirement
Now that we laid out why the withdrawal amount is such a big factor and how the devil is in the details with this factor, let’s turn our attention to the second factor -- the duration of retirement. There are a lot more complexities to this assumption as well, and it deserves further discussion.
Of course, this is impacted by two dates – the date that one retires and the date of one’s death. If you know those two dates, you know the duration that you will need to make withdrawals from your portfolio.
Retirement Date – The First Date in Calculating the Duration of Retirement. You may be able to control one of those dates more than the other. While one arguably has the ability to control one’s retirement date, be careful because this is not always the case. The best laid plans of man often go awry and setting the retirement date may not be totally within our control. That sounds like a topic for another blog or episode – we can discuss why we may not have as much control of our retirement as we think and look at some statistics behind that. We can also cover adjustments you can make if a surprise early retirement happens, but for now we will assume you can control your retirement date.
Since the retirement date is a factor that you have some control over and since such date has a big impact on your life, this factor obviously deserves a lot of attention. If you are in your 30s and 40s, unless you adhere to the FIRE movement you really don’t know or don’t care about the retirement age as much. As you get into your 50s, many of you are likely beginning to think about the age that you would like to retire. We often talk about an ideal retirement date versus an acceptable retirement date. While I suggestthoseearly in their career think strongly in those terms, it is especially important if you are 15 or so years away from retirement to explore potential retirement dates. The age of retirement has a huge impact on how much you need on Day One so it is important to nail this down.
If you decide to retire at the earlier date (or are forced to retire at the earlier date), not only are you adding to that duration factor, you are missing out on one year’s worth of additional income and savings. Many of the folks we work with usually have a range of 2 – 5 years at which they are thinking about retiring. It might be 60 or 65 or 64-67…whatever.
It is important to consider two extremes in retirement dates to understand the tradeoffs – how much more do you need to save in one scenario versus the other or how much more can you spend in retirement in one scenario versus the other. By considering different retirement dates, the duration will change and the action that you will need to take before retirement will change. So, the retirement date should indeed drive many decisions well before retirement.
While we won’t explore the details on this blog and episode, the retirement date could indeed impact other strategic decisions like asset allocation, income tax strategies, spending, and a host of other issues that need to be considered.
We have thrown around a lot of issues related to the retirement date and certainly don’t have time to delve deeper at this point, but we are looking forward to resurrecting those issues in later blogs and episodes. Again, the retirement age is a factor that impacts the duration of retirement which is a critical input to help calculate how much one needs on Day One of retirement.
Longevity – The Second Date in Calculating the Duration of Retirement. As mentioned, the beginning point in figuring out the duration in retirement is the retirement date. The second date to figure out the duration of retirement is one’s date of death. Now, while we do have a certain element of control over our life expectancy, we obviously do not have total control and it can be tough to predict. That makes retirement planning – and figuring out the amount that one needs on Day One – that much more difficult.
Again, we don’t have time in this blog or episode to cover longevity, successful aging, and other fascinating topics in depth, we do want to say that it is wise to be conservative in forming this assumption, i.e., it is best toassume a life expectancy longer than an average life expectancy.
No one wants to run out of money during life. No one wants to have to rely on kids, grandkids, or the government in old age to provide for life’s basic necessities or life’s pleasures. If you ask most people if they would rather die with a little too much money because they planned conservatively or if they would rather be reliant on relatives in their late 80s because they did not plan to live past an average life expectancy that they had figured for planning purposes, most would say that they would rather pass away with some money in their bank account at death.
For example, if age 85 is the life expectancy of someone at age 65, we don’t want to use age 85 because there is a decent probability –greater than 50% -- that one lives past the average life expectancy. The key is to understand your health history, your family genes, and the general life expectancy tables to come up with a proper assumed life expectancy. When we run the analysis for our clients, we typically use age 93 to 95, but this obviously varies amongst individuals. Other factors can sway us to use a different life expectancy. Again, there’s a lot to talk about here for another blog or episode, but suffice it to say that the age of life expectancy is a critical factor and another reason as to why simple rules of thumb or simple quick calculations may not be in one’s best interest in planning for retirement.
We will provide a link to some online resources that may help you think through the life expectancy.
Variable #3 in Retirement Funding Calculation: Adjusted Rate of Return
Thus far, we have reviewed two of the three main inputs in deciding how much one needs on Day One of retirement. We discussed the withdrawal amount and the duration of retirement. If you are using your financial calculator, that is the “pmt” button for withdrawal amount and the “n” button for duration. The final main input for this simple retirement calculation is the adjusted rate of return.
Note that it is an “adjusted” rate of return because the assumed rate of return is adjusted for inflation. What is adjusted for inflation? Well, effectively, the withdrawal amount is assumed to keep up with inflation so that your standard of living stays consistent throughout retirement.
Remember, we discussed how expenses can vary in retirement, but for these purposes we should assume the expenses increase by inflation. While detailed financial modeling provided by a professional financial planner should go into more depth with this calculation, the way we can incorporate inflation into our basic calculation is by adjusting the rate of return that we use. The inflation rate is difficult to predict in both the short-term and and long-term. One of the Fed Reserve’s goals is to keep the inflation rate down, but it is still difficult to predict what tomorrow’s inflation rate will be. Except for these past few months, the inflation rate has been relatively low and relatively tame for the last several years, but we can’t assume too low of an inflation rate in the future. For long-term analysis, you may want to use between 2 – 3%. We typically assume 2.5% for most expenses. Some expenses like health care may increase more than your typical inflation rate. In our simple calculation, we don’t have the luxury of assigning different inflation rates to different expenses.
Adjusted rate of return varies by individual. After settling on the inflation rate, you need to make an assumption on the assumed rate of return of your retirement portfolio. This factor also plays a huge role in figuring how much one needs on Day One of retirement and it can be more complex than a simple calculation might suggest. Like the other factors, you probably want to be slightly conservative in this assumption. The rate of return will be impacted by the type of portfolio you or your advisor constructs, which should be based on a variety of factors, including risk capacity, time horizon, cash flow needs, and other factors. Depending on how you included income taxes in your withdrawal amount, you may also want to adjust your rate of return by income taxes.
Expected rates of return - using capital markets are mere estimates. Outside of the income tax question, one of the biggest complexities in the adjusted rate of return is the expected rate of return. The starting point is to consider what mix of stocks and bonds you might have in retirement and look at what the capital markets assumptions would suggest for that kind of portfolio. You can look at history or get some assumptions from economists for the long-term, but these would just be estimates for your situation.
What asset classes to use? Adding more complexity to this, you need to determine how precisely you areinvested in stocks and bonds sincenot all bond and stock asset classes have the same expected return. For stock returns, many individuals and planners keep this simple and use a rate of return that the S&P 500 would produce. Much of the financial media reinforces this focus on large cap returns since they compare almost all investments to the S&P 500. While this approach has the benefit of simplicity, it assumes that you will only be invested in U.S. large cap stocks. While we are all for simplicity when we can get it, even in constructing retirement portfolios, keeping things too simple may result in a lower return than what one could otherwise receive. This, in turn, could require one to have more on Day One of retirement or would require one to have lower withdrawals in retirement.
Be cautions of assuming averages. Even if we all had the same exact type of portfolio – the same mix of stocks and bonds and the same sub-asset classes of stocks and bonds – what kind of rate of return should we assume? If we assumed the average rate of return, there’s a 50% probability that the return will be lower in any one year. If our particular retirement years were less than average, then perhaps we would find ourselves running out of money earlier than we expected. So, we may not necessarily want to assume that we get average returns. This assumption alone will have a tremendous impact on “how much is enough?”.
Level of confidence desired. With the idea that we should be somewhat conservative in the return assumpltions, how low of a rate should we assume? This really depends on the level of confidence you want in retirement and there are a few different approaches for this. One conservative approach is to look at historical markets and use the number that represents the lowest ten percentile for a respresentative period of time (e.g., 30-year rolling periods). Again, the past is not a guarantee of future performance, but it could be a good conservative number to use as a starting point. Or, you can use the average rate of return to just give you an idea of some expectations if you were able to produce averages.
Consider volatility in the real world. But, using any one rate of return in this simple calculation somewhat ignores the volatility in the markets and the timing of that volatility. In the real world, markets never get the average. In any one year, the markets can be close to the averages on the upside or downside or they can be quite a bit higher or they can be quite a bit lower, of course. And, the timing of the returns in relation to when you retire can have a big impact.
We call this sequence of return risk, and it is important to manage this risk appropriately. This, too, would be an excellent topic for future blogs and episodes as there can be a lot of planning and risk mitigation for this issue. There is an alternative approach to take the annual volatility into account in measuring how much one needs on Day One of retirement and that is to use some form of Monte Carlo analysis. In brief, Monte Carlo analysis attempts to stress test the portfolio in retirement based on many different factors. Again, we won’t go into detail on Monte Carlo analysis in this blog or episode, but it’s an additional way that will complement the more simplistic straight-line analysis. As we bring Monte Carlo analysis to our retirement planning, we realize that we may need 20% to 40% more than what our basic calculations would suggest. This is because we want to plan for some worse case scenarios, and the Monte Carlo approach attempts to do that. Even long periods of time can produce different returns.
While you don’t need to factor in all of these complexities in doing a high-level review of your retirement situation, those variables relating to the adjusted rate of return input provides another example of why using a simple adjusted rate of return number for calculating how much you need on Day One of retirement may be too simplistic and lead to somewhat inaccurate results.To wrap up, figuring out how much you need on Day One of retirement can involve a basic calculation using three simple factors – the withdrawal amount, the duration, and the rate of return. It becomes more complicated when you begin to break each factor down and take into account the uniqueness of all of our life plans at retirement and the volatility of the market. Nevertheless, this simple calculation is a good start for understanding whether you are in the ball park of meeting your retirement goals and providing some impetus to seek further help whether you want to pour into the research and analysis on your own or seek a professional’s help.